Iceland has taken its medicine and is off the critical list

It was one of the defining moments of the financial crisis. With Lehman
Brothers in bankruptcy court, the global banking system in seizure, and
taxpayers across the world riding to the rescue, the British Government took
the dramatic step of invoking terrorist legislation against its NATO ally
Iceland.

The problem was that Iceland, with a population of 320,000, could not afford to bail Landsbanki outPhoto: AP

Iceland was not threatening an attack on the UK, but it was threatening to deprive 300,000 British savers of the £4bn they had deposited in Icesave – a subsidiary of Landsbanki, which had been nationalised just days earlier.

The problem was that Iceland, with a population of 320,000, could not afford to bail Landsbanki out. Recognising that either the British taxpayer would have to foot the bill or customers would lose their savings, Gordon Brown acted. It was October 2008.

Geir Haarde, Iceland's then prime minister, later said: "The actions of the Brown government were shameful. They put a friendly country like Iceland on a list ... alongside al Qaeda."

But Brown had good reason to want to seize the assets. Iceland's banks had outgrown the country. The liabilities of the three main lenders were almost 10 times the size of its GDP. When investors baulked at the scale of their debts and all three faced collapse, the Icelandic government stepped in. But it could not afford to rescue them. The UK has still to recover the £2.3bn Iceland owes the taxpayer.

Instead, in a few dramatic days, Iceland tore up the traditional rulebook. First, retail depositors were given priority over bondholders. Then, alongside the deposits, all domestic assets were transferred to new banks at "fair value" – the shrunken, market price of the debt. The new banks, recapitalised by the state, took over the vital payments system that kept the wheels of the economy turning.

The international operations and the foreign creditors, though, were put into liquidation. In effect, foreigners bore the brunt of the collapse – taking huge losses on their Icelandic exposures. In the process, Iceland's banking assets shrunk from 10 to two times the size of the economy.

Although the bulk of the burden was borne overseas, Iceland suffered hardships, too. The krona collapsed, by 90pc at one point, causing a spike in import costs. Inflation hit 18pc and unemployment jumped from 2pc to 9pc.

In the wake of the crisis, the social fabric frayed. Riots broke out and effigies of politicians were burned. Shut out of the international money markets and with the country's economic model broken, Iceland tapped the International Monetary Fund for a $2.1bn emergency loan. The old government was toppled and a new one sworn in.

The IMF was an immediate stabilising influence. Rather than preach austerity, it backed a state-sponsored stimulus package, agreeing to postpone planned cuts for a year. Poul Thomsen, a director of the IMF's European department, said in December 2008: "We think it is wrong, in the face of a deep recession, to embark on fiscal consolidation."

The Icelandic government then took unorthodox measures to alleviate the debt burden on households. Banks were made to accept reductions in mortgage interest payments of up to 40pc, while the most distressed households had some of their debt written off.

The medicine is working. The economy contracted 6.8pc in 2009 and another 4pc in 2010, but bounced back to grow 3.1pc last year. The IMF has been repaid and, in February, the country regained its investment grade credit rating after Fitch raised it from the "junk" status of BBB- to BB+.

In June last year, the government even tapped the markets for a $1bn sovereign bond issue, leading Paul Krugman, the economic nobel laureate, to note: "The idea there would be a huge reputational penalty for allowing private sector parties to default on external obligations has not turned out to be true."

The country is not back to full health, by any stretch of the imagination. The economy is still 10pc smaller than it was, and unemployment above 7pc. The public finances have been trashed. Before the crisis, Iceland had a 5.4pc budget surplus, net debt of just 11pc of GDP, and growth of 6pc. Last year, the budget deficit was 4.6pc and debts were 65pc of GDP.

Capital controls erected in October 2008 remain in place, posing questions about the country's prospects once they are dropped.

But compared with Ireland, which has seen national debt soar from 11pc to 96pc of GDP after bailing out bank bondholders rather than cutting them loose, Iceland has been an amazing tale. It may have been so small as to be irrelevant to the global financial system, but the IMF has said there are lessons to be learned. Spain, whose banks pose a much greater risk than its public finances, is a case in point.